The Great Herbalife War of 2013

Dueling hedge funds battle over whether the nutritional supplement company is a pyramid scheme.

The first great financial war of 2013 has started, and it has nothing to do with Greek bonds or the debt ceiling or the Grand Bargain. Instead, it’s a hedge-fund-on-hedge-fund brawl about multilevel marketing of weight-loss supplements.

In one corner is Bill Ackman of Pershing Square Capital Management, in the other is Daniel Loeb of Third Point Capital. Both Jewish, both born in the 1960s, one from New York, one from Los Angeles, one educated at Harvard, one educated at Columbia, one long Herbalife and one short Herbalife. Herbalife describes itself as a “global nutrition company” that sells its products through its exclusive network of dealers. Ackman (short Herbalife) says it’s an illegal pyramid scheme that should be shut down by regulators, thus cratering its stock and making him a nice pile of money.

Loeb (long Herbalife) is best known for seeking out firms that he thinks have become undervalued because of mismanagement, and then shaking things up to increase the underlying value. He was a key architect of a campaign against Yahoo’s board early last year that led to a proxy battle, the ouster of a CEO, and ultimately the reorganization of Yahoo’s financial assets to create more money for its shareholders. In the case of Herbalife, Loeb’s making a simpler play. His claim is simply that Ackman is mistaken, and that his short-selling and propaganda campaign artificially depressed the price of Herbalife stock. In response, Loeb bought up 8.2 percent of the company after Ackman’s statements led the price to fall. All Loeb has to do to earn a return is ride out the storm.

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A pyramid scheme, in its most stripped-down form, is like a chain letter. You send a letter to five people with instructions to each of them to forward the letter to five more people. For a while it’s good clean fun, but after 15 iterations you’re up to 6 billion recipients and they’ve got nobody left to forward to. The same basic concept can be turned into a financial scam. I get an initial group of financiers to give me money to invest. Then instead of investing the funds, I pocket the cash and simply raise a new round of funding from a larger circle of investors. Some of their money goes to pay off the first round of investors, and some of it goes to line my pockets. Then you need yet another round of investments. Eventually the whole thing blows up, but the early investors can make a nice pile of change.

Of course, nobody would willingly invest in a company known to have that structure. So the Bernie Madoffs of the world cloak their pyramid schemes in fraud. Ackman’s allegation is that Herbalife is doing a version of this.

In principle, there’s nothing wrong with multilevel marketing. The way it works is that instead of advertising and marketing, you sell products directly, person-to-person. Some of your best customers can then be recruited to work as distributors themselves, and sell to their networks. This is not an illegal pyramid scheme, but it does have a pyramidal structure that makes it a possible vehicle for such schemes. And that, says Ackman, is exactly what’s happening at Herbalife, which he says “is in the business of selling dreams, not weight management products.”

A presentation on the FactsAboutHerbalife.com site set up by Ackman quotes Herbalife CEO Michael Johnson as saying “what we’re doing at Herbalife, is we’re building the best business opportunity on the face of the Earth.”

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That, to Ackman, is exactly the problem. The company isn’t really in the business of selling protein supplements and using multilevel marketing to sell them. It’s in the business of selling distributorships and using weight-management products as a vehicle. Pershing Square believes that the vast majority of distributors earn little-to-no income while, crucially, those who do earn income earn the vast majority from selling new distributorships rather than selling actual products. Key to his argument is that all Herbalife is selling is commodity products (as witnessed by the company’s scant R&D budget) at inflated suggested retail prices. That’s not a business that can possibly sustain Herbalife’s profit margins, suggesting the real business is the distributorships themselves—which would put the company squarely into the danger zone identified in previous case law on pyramid schemes.

The company and Loeb say this is a total misrepresentation. They cite a Lieberman Research survey indicating that about 5 percent of American adults have tried Herbalife, note that competing firms with different marketing strategies such as GNC also have little research and development spending, and, most of all, say that up to 70 percent of distributors joined up to gain access to wholesale prices, not as part of a get-rich-quick scheme or a fraud.

As far as Ackman’s bet, it would be a long shot for the Federal Trade Commission to step in and essentially destroy a company at the behest of a hedge fund. But viewed in a certain light, Herbalife’s self-defense is damning. The company is essentially saying that it’s not a fraud; it’s a run-of-the-mill business in which customers buy distributorships in order to gain discount pricing on overpriced stuff. That doesn’t necessarily mean it’s a bad business. Monster, Inc. seems to do a nice business selling overpriced electronics cables of various kinds, and Beats By Dre has achieved frighteningly large market share with its overpriced headphones. There are all kinds of ways to make a buck in the world, and many of them are dishonorable without being illegal. If Pershing Square can essentially bait Herbalife into explaining its business model in a high-profile way, that alone might damage the company and make the short play pay off.

But for now Ackman’s bet against Herbalife looks to be in trouble. Shares in Herbalife tumbled to $24.24 on Dec. 24 when Ackman revealed his campaign. But they rallied on Loeb’s vote of confidence and they soared Monday morning all the way back to pre-short highs. Now the company’s in a position to squeeze short-sellers with a large buyback program that will push shares even higher. A short-seller is exposed to potentially infinite losses if the target firm’s shares go up and up, so it’ll be a nerve-wracking moment for the participants. But for those of us who are just spectators, it’s a case—an all-too-rare case—of the financial system acting in a real way to test and probe the actual economy. Herbalife’s various accounting and business practices are now being but under the microscope in a way that doesn’t happen to most companies. If the company survives, it’ll be by withstanding scrutiny rather than flying under the radar—exactly the way it should be.